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Taxation (Edexcel A Level Economics A)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Progressive, Proportional & Regressive Taxes

  • Tax systems can be classified as progressive, proportional or regressive

  • Most countries have a mix of progressive (direct taxation) and regressive (indirect taxation) taxes in place

  1. Progressive tax system: as income rises, a larger percentage of income is paid in tax (e.g. UK Income Tax; UK Corporation Tax). This system is built around the idea of marginal tax rates

    UK Progressive Tax Rates - June 2022

    Tax Band

    Taxable Income

    Tax Rate

    Personal Allowance

    Up to £12,500

    0%

    Basic Rate

    £12,501 to £50,000

    20%

    Higher Rate

    £50,001 to £150,000

    40%

    Additional Rate

    Over £150,000

    45%

    Using this system, a salary of £60,000 would attract a tax bill of £11,499.80, calculated as follows:
    First £12,500 - no tax
    Next £37, 499 at 20% = £7499.80
    Final £10,001 at 40% = £4,000

  2. Regressive tax system: as income rises, a smaller percentage of income is paid in tax (e.g. excise duties on alcohol and petrol in the UK; VAT; Air passenger duty). Regressive taxes can have a big impact on low-income households. In 2020 they represented 30% of income for the poorest 20% of households - but only 10% of income for the top 20% of households

  3. Proportional tax system: the percentage of income paid in tax is constant, no matter what the level of income e.g 10% tax is paid irrespective of whether income is £10,000 or £100,000. Bolivia uses this system and the tax rate is 13%

The Economic Effects of Changes in Tax Rates

  • Changes in direct and indirect tax rates influence a range of economic variables

    • The greater the size of the change, the greater the ripple effects through the economy

Effects of Tax Rate Changes

Impact

Explanation

Incentive to work

  • The higher the tax rate, the lower the incentive for the unemployed to seek work - or for existing workers to work overtime

  • In 2022, the Adam Smith Institute calculated that average earners in the UK work from the 1st January to the 8th June (Freedom Day) to pay their taxes - all income after that point belongs to them

Tax revenues

  • The Laffer curve illustrates the relationship between increasing tax rates and the level of government revenues received

  • The broad idea is that as tax rates increase, a point will be reached where disincentivized workers work less resulting in less income and less government tax revenue. More people will actively seek to avoid paying tax (tax avoidance) or try to move their income elsewhere

4-5-2-laffer-curve
The Laffer Curve demonstrates the relationship between tax revenue and tax rates

  • Tax rate increases up to point A, will result in an increase of tax revenue.  Further tax rate increases from A to B result in a loss of tax revenue from C to D

Income distribution

  • A progressive tax system redistributes from those with higher income to those with lower income and reduces income inequality

  • Sometimes the benefits of a good progressive tax system are eradicated by the penalties imposed through multiple regressive (indirect) taxes

Real output and employment

  • If the tax rate increases, more money is withdrawn from the circular flow of income (leakage)

  • This will likely cause a reduction of aggregate demand (AD) as firms and households have less disposable income

  • As AD slows down, fewer workers may be required for production and unemployment may increase

Average price level

  • An increase in indirect taxes reduces disposable income and so workers may petition their employer for a salary increase

  • If they receive the increase the economy may face a wage-price spiral

  • Indirect taxes also increase costs of production for firms possibly leading to cost-push inflation

The trade balance (X-M)

  • An increase in taxes can reduce disposable income which is likely to reduce the level of imports

  • This may improve the trade balance (exports - imports)

Flows of Foreign Direct Investment (FDI)

  • If the rate of corporation tax increases relative to other countries, it may result in less inward foreign direct investment

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    Author
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    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

    Jenna Quinn

    Author: Jenna Quinn

    Expertise: Head of New Subjects

    Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.